Protecting your interests in a group investment (Part 2)

Note: This post is part of a series of posts on the fundamentals of partnership agreements and investing as part of a group. See the introduction to the series here.

What are my interests and how do I determine them?

So in our series here we've been dealing with a fictional Subway franchise start up. I'll freely admit right now that I know very little about terms and conditions relating to Subway franchises so some information I present here may be inaccurate depending on the paperwork you have to sign with Doctors Associates Inc (the owners of the Subway brand). However, in general the concepts here should pertain to most situations, especially companies that are wholly original (not beholden to any super-brand company).

So what are your interests in your new investment? Generally, if you are putting forward money to advance this business, you'll want to be paid back in one of two ways. If you loan the money to the new company you'll form a bond and want to dictate terms of interest and a repayment schedule. However that would make you a creditor, not a partner, so we'll over look that possibility for now.

The second way to be paid back is to own a portion of the company. In essence, you'll be a stock holder in a privately held company (though partnerships do not need an official issuance of certificates). How much of the company should you own? This is often the first, and most difficult, question to answer. The answer can only be found through long negotiation between all interested parties. When negotiating your share of ownership interest, here are a number of concepts that should be considered.

Capital Invested. Who is going to be fronting the money, and how much? In our hypothetical example let's pretend that Uncle Joe is starting the Subway franchise but he's asking you to front 70% of the capital. A good starting place for the ownership discussion would be starting the shares according to the monetary investment, giving us a launching point of owning 70% of the company.

Expertise. Is the company going to be relying on the expertise of any of the partners? Maybe Uncle Joe managed a successful Burger King for 15 years and has the know-how to hire the right people and run the day to day operations. In a real estate partnership maybe one of the investors is a lawyer who knows how to get property re-zoned according to the investment strategy. In both cases, the partners who bring expertise to a company have a stronger negotiating position.

Level of Effort. Are one or more of the partners going to be investing significantly more time into the company than the others? Maybe Uncle Joe intends to manage the Subway full-time, while you sit back and do very little in the day-to-day operations. This work can be compensated in two ways. He can be paid a regular salary, or he can be compensated through greater ownership. Most likely it will be a combination of the two, with him taking a lower-than-average salary to help the company through it's early times, but in return taking a slightly larger ownership interest.

Referring back to our other example, let's say that we intend to get some investment property re-zoned and one of the investors, the real estate lawyer, will be the one to do so. He expects it to take a couple of weeks to fill out and file all the paperwork. The partnership can either reward him for his effort with a larger share of the partnership, or it can offer to pay him for his work (leaving his ownership level the same). Note that if the partnership pays him he will earn money regardless of the success of the investment. Offering him a larger share will link the return on his effort to the success of his filing.

In the end though, determining the ownership shares for the individual investors lays entirely on the shoulders of the individuals. There is no simple formula that can be used, instead it's simply reliant upon the negotiation skills of those included, which is why mergers between companies can take months as professional negotiators debate every fine point.

Obviously the more important the partner is to the success of the business, the larger a share they can command. A good question you can ask yourself repeatedly during this stage is, "What are my odds of success if I found someone else to replace this partner? What would my partner's odds of success be?" Could he find someone else willing to finance the investment? Could you find someone else to replace the knowledge he provides?

In the case of Biff and I, we each brought certain advantages to the table (my accounting and financial skills and his proximity to the properties) and we agreed to split all expenses 50/50. So even though Biff had a slight advantage in our negotiations (it would probably be easier for him to find someone financially gifted, than it would be for me to find someone I trust who lives in an affordable area), he didn't push because he knew that we'd both be profiting from our joint venture. Many small group investments go the same route, splitting costs, workloads and ownership equally. But each situation is unique.

In our hypothetical example, we finally settle on giving Uncle Joe a 45% ownership share based on his 30% capital investment, his expertise in the field and his offer to take a small pay-cut until the business turns a profit for 3 consecutive months. The good news is that once we've reached this point we've already answered a large number of questions including:

  1. Who is going to invest in the company?
  2. How much does each partner contribute?
  3. What is the role of each partner in the company?
  4. How much of the company does each partner own?
We're now well on our way to collecting more of the information we'll need before we draft our partnership agreement.

Introduction - The basics of entering a group investment
Part 1 - What a partnership agreement is, and what you need to know about it
Part 2 - What is my interest and how do I determine it?
Part 3 - Figuring out the managment